National Institute of Economic and Social Research

Sunday, 16 September 2012

Sterling: my part in its downfall

[this post was published September 17, 2012 in Juncture, the journal of the Institute for Public Policy Research]

The economic and political history of the UK's ill-fated
experiment with the Exchange Rate Mechanism (ERM) has been picked over many
times, and the broad outlines of the story are well known (for a range of
well-informed views, see here).
So this is more of a personal recollection of how it felt at the time.

I spent the night
and early morning of April 9, 1992 – the General Election - in front of the TV,
with my then boss, Jeremy Heywood, now the Cabinet Secretary, and our friend
Suma Chakrabarti, now running the European Bank for Reconstruction and
Development. As the result became clearer, Suma and I got
drunker, and more voluble; Jeremy chain-smoked, and remained as impassive as
ever.

So when I arrived at the Chancellor's Office in the
Treasury the next morning, I was less than usually tactful (yes, this is in
fact possible). The first thing I said
to Norman Lamont (who was, I suspect, equally hung over) was "I wasn't
really expecting you to be here today". He replied "Me neither."

And so we returned to work (I was Norman's speechwriter). While the Conservative Party as a whole was
understandably euphoric at their surprise victory, the elation didn't last long
for those responsible for economic policy. The economy was also suffering from
a severe, and much longer-lasting hangover.
The hubristic tax-cutting of Nigel Lawson and the financial sector
excess of the late 1980s had led to a surge in inflation and a rise in interest
rates; we were still bouncing along the bottom of the ensuing recession. If all this sounds vaguely familiar, it should.

In May 1992, the immediate problem was obvious. From a domestic point of view, the
appropriate level of interest rates, given weak demand, was much lower than that
necessary to maintain sterling's position in the ERM. Moreover, it was becoming increasingly clear
that sterling was overvalued; even in the depths of a recession, we still had a
large current account deficit. However,
the government, and Treasury, line was that there was no alternative; things
would eventually get better.

I didn't believe it. My willingness to argue a different
line to the entire senior Treasury management was probably a mixture of sound
instinct and youthful arrogance, and I was sufficiently unimportant that I
could just about get away with it. Jeremy
and I wrote a short, private, paper for the Chancellor. We argued that the
fundamental problem was that we'd joined the ERM at the wrong rate; sterling
was overvalued, meaning that we were stuck with a structural current account
deficit. The only way to maintain the peg would be through what is now, in the
eurozone context, referred to as "internal devaluation"; that is,
real interest rates at a higher rate than dictated by internal conditions, and
a long and grinding squeeze on wages and prices.

Our solution? We
didn't dare suggest complete abandonment of the ERM. One possibility was for sterling to
"realign", that is devalue, to a considerably lower rate, boosting
exports and allowing interest rates to fall. Even better, politically and
perhaps economically, would have been if the Germans could have been persuaded
to realign upwards, so avoiding the perception that sterling was being singled
out; but the French were resolutely opposed to any devaluation of the
franc.

Could either route have worked, keeping the UK in the ERM?
In restrospect, probably not; it is very difficult to "manage" a
devaluation, because no one knows the "right" rate. An attempt at managed devaluation would
probably have led to unmanaged exit. So a final, more radical but perhaps more
plausible option was to leave temporarily, allow sterling to find its own
level, and then rejoin when both the currency and interest rates had
stabilised.

In any case, none
of this was going to happen. Norman called us in. He said (I paraphrase)
"I've read this. Broadly, I agree.
But forget it. What I want to do instead
is to make a speech setting out the best possible case for the UK's membership
of the ERM."

I started writing, and together we wrote what Norman and
I both agreed was easily the best speech we produced during his time as
Chancellor. It set out, carefully and
logically, the reasons why ERM exit would be a disaster for Britain. The UK had long suffered from periodic cycles
of boom and bust, most recently exemplified by the deep recession of the early
1980s and the unsustainable boom of the late 1980s. Monetarism - targeting various measures of
the money supply - had failed miserably.
The alternative was to "import" credibility from a country
with a demonstrated record of maintaining low inflation while avoiding boom and
bust - Germany, and we could do exactly that by tying our exchange rate and
monetary policy to theirs.

And the early experience of the ERM was relatively
positive; our interest rates did converge somewhat with Germany's at the same
time as inflation fell. Leaving now would be a disaster: without the discipline
of the ERM as a monetary anchor, wage pressures would rise, and so, in turn,
would inflation; this in turn would result in higher interest rates, both
shorter and longer term, choking off recovery.
The consequent fall in sterling would further exacerbate inflationary
pressures. Nor would there be a rapid
return to growth; you couldn't devalue your way out of a recession. In the
longer term, we'd be back to boom and bust.

Almost all of this turned out to be wrong, of course, but
it was a clear, coherent, and - we thought - convincing statement of the
government's case. In domestic political terms, it had the desired effect. In the international financial markets,
however, things were gradually slipping out of control.

So what happened next? Well, the high pressure atmosphere
of Private Office was beginning to burn me out.
I didn't think I'd ever write a better speech (although I am also happy to take partial credit for "green shoots"). And somehow I'd managed
to blag the Treasury into sending me to Princeton to belatedly learn some
economics. So by the time of Black
Wednesday, I'd moved to the US.

I did see Norman shortly thereafter. We were both in Washington DC, and we drank
champagne on the Embassy terrace and discussed that day's referendum on the
Maastricht Treaty in France (51-49 for "yes", if you've
forgotten). He was cheerful, although
well aware of the impact of ERM withdrawal on both his credibility and that of
the government as a whole; this was the night before his famous "singing
in the bath" remark to the British press.

And indeed, liberated from the constraints of a policy
that he did not believe in, Norman's macroeconomic strategy was exemplary. He
moved quickly to introduce an inflation targeting regime, pioneered in New
Zealand and Canada just a couple of years previously. It was extremely successful, establishing
credibility remarkably quickly, and prepared the ground for full Bank of
England independence.

The success of fiscal policy in the 1990s, under first
Norman and then Ken Clarke, is less well
known. But, as I argue here, he
made the right decision for the right reasons, in sharp contrast to George
Osborne. Policy was tightened sharply, but
only after recovery had been firmly established, rather than, as now, before.
While there are of course a number of reasons why the post 2009 experience has
been so different from the post 1992 one, despite a similar devaluation, the
failure of the current Chancellor to learn from the success of his Conservative
predecessor is clearly one.

What did I learn?
Well, there are numerous economists who, if you asked them what Black
Wednesday implies for the conduct of monetary and exchange rate policy, could happily
start a fight in an empty room. But for me, the most important lesson was a
more general one about "credibility"- a concept often used and abused
by both politicians and economists. As
with the ERM, the argument made by the current government and its supporters
for sticking to its fiscal consolidation plan, despite its evident failure, is
that the strategy has established "credibility", especially with
financial markets, which can only be preserved by sticking with it.

But of course this is not a
justification, economic or otherwise, for the policy. Instead it is an argument
for never changing policy at all. It
relies on an odd view of market psychology, one that says markets have more
confidence in governments that never adjust policy, even when it is sensible,
from an economic perspective, to change course.
But, as Black Wednesday (and numerous other examples from economic
history) show, this is not plausible. Markets can, of course, be irrational.
But there is neither a theoretical reason nor any empirical evidence to suggest
that they are irrational in this particular way. The real hit to credibility
comes from sticking to unsustainable policies; and economic success comes from
abandoning them and doing something sensible instead. That is one lesson from
Black Wednesday we could usefully remember.